Question

You own an oil pipeline that will generate a $2.2 million cash return over the coming year. The pipeline’s operating costs are negligible, and it is expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 2.5% per year. The discount rate is 6%.

a. What is the PV of the pipeline’s cash flows if its cash flows are assumed to last forever? (Do not round intermediate calculations. Round your answer to the nearest whole dollar amount.)

Present value            $

b. What is the PV of the cash flows if the pipeline is scrapped after 16 years?

Answer 1

a)

Present value of cash flows = annual cash flow / required rate - growth

Present value of cash flows = 2,200,000 / 0.06 - ( - 0.025)

Present value of cash flows = 2,200,000 / 0.085

Present value of cash flows = 25,882,353

b)

The pipeline value at year 16 = C1 / K - G

The pipeline value at year 16 = [2,200,000 ( 1 - 0.025)¹⁶ / 0.085]

The pipeline value at year 16 = 1,467,224.371 / 0.085

The pipeline value at year 16 = 17,261,463.18

Present value of 17,261,463.18 = 17,261,463.18 / ( 1 + 0.06)¹⁶

Present value = 6,794,910.832

PV of cash flows = 25,882,353 - 6,794,910.832 = 19,087,442